The age of competitive currency devaluations

This article appeared originally in Gulf News: link to original article

China has always been accused of manipulating the markets to exert a downward pressure on the yuan.

Though not directly and explicitly expressed, it was understood by analysts to be a tactic to continuously support their export sector. The trade-off is that a weaker currency, though it encourages exports, reduces the purchasing power of citizens of the country.

The counter argument then is that an economy highly dependent on exports would create more jobs, increase income per household and reduce poverty. Sure. And China did in fact lift 500 million people out of poverty with reforms implemented since 1978.

I would say here that any of the two arguments would be of more importance based on where a country stand in terms of its population, its income per capita and more precisely what percentage of its population is either poor or at a financial status that is below the poverty line.

In a nutshell, different countries have different backgrounds — and hence reasons — to either depreciate or appreciate their currencies, whether directly or indirectly. The focus of this report would be on the different types of exchange rates and their pros and cons.

It will also address what countries do to either cause their currency to appreciate or depreciate, taking into account recent highlights. According to a paper published by the IMF in 2014, ‘The Cost of Tying One’s Hands’, exchange rates can be broadly classified into ‘fixed, intermediate, and floating’.

The first is the direct peg that we know of. So, for instance, $1 is equal to Dh3.672. A country would adopt such a measure based on the bilateral trade between it and the other country, and having a fixed exchange rate would make the exchange of goods and services smooth and almost shielded against daily exchange rate fluctuations.

Also, let’s not forget that no one quotes a barrel of oil in Chinese yuan or in euros. There is no definite indication of whether or not a country bases its judgement on a certain percentage of bilateral trade that it has with a certain country, compared to others, to decide to peg its currency. Or perhaps pegging the currency if the country is the number one trading partner.

The US as a case is special as the dollar is among the IMF’s official reserve currencies list and is an anchor currency. Another point to be stressed here is that the percentage of bilateral trade from the total influences a country’s decision on what mix of currencies it should hold in its reserves.

So, have you wondered why are reserves expressed in dollars? The intermediate type is what can also called an indirect peg. A good illustration would be the dirham being pegged to the dollar (anchor currency). Kazakhstan’s tenge is also pegged to the dollar, but neither of the two currencies (dirham and tenge) are pegged to one another.

The main advantage here would be that those two currencies, or any other in a similar setting, would not fluctuate sharply against one another. The same IMF paper states that fluctuations are steeper than in the case of a direct peg, but are milder when compared to a floating exchange rate.

The Russian rouble is not pegged to the dollar, and the rouble has lost more 50 per cent of its value since last year. This is what having a floating exchange rate means. The US and China also have a floating exchange rate.

The IMF paper argues that such a rate enables currencies to adjust according to market conditions, and not to what countries do to adjust their currencies’ values even if measures taken by their central banks work. The same paper points out that in the case of the US and China, the dollar could not correct itself against the yuan in a way that would reverse the US’s trade deficit with China.

Now this can be the result of the US dollar being an anchor currency, China reduces the circulation of dollars by investing its surpluses in US Treasuries, and the People’s Bank of China has injected money into the economy on several occasions.

The latter presumably stimulates economic growth via banking activities, but also depreciates the yuan or keeps exerting downward pressure on it. So here comes today’s dilemma.

When currencies’ values don’t correct themselves based on market changes, countries try to interfere and make that happen. One way to do so is by unpegging a currency if it is pegged, allowing the currency to float and the exchange rate to adjust based on market conditions.

The result of such a decision can be a sharp increase in a currency’s value, like what happened when Switzerland decided to unpeg its exchange rate with the euro. What led the Swiss National Bank (SNB) to take this step was that, as investors started buying francs and investing in Switzerland, the currency appreciated to a point that would hurt an economy where exports make 70 per cent of GDP.

Therefore, the SNB kept buying euros to maintain the peg rate, ensuring no unwanted franc appreciation takes place but inflating its balance sheet and risking a higher inflation rate. Another way to do this would have been to cut rates, which the SNB reverted to later when the franc appreciated sharply.

The other major measure that could be taken, and has gained lots of attention in the midst of the financial crisis, is Quantitative Easing (QE). The US, and Japan more heavily, went into purchasing assets via the Federal Reserve (Fed) and Bank of Japan (BOJ) respectively while printing more of their currencies, the dollar and the yen.

Doing so, both countries were trying to achieve a 2 per cent targeted inflation rate and Japan wanting to finally exit its deflation nightmare. This of course also aims at depreciating the currency’s value and thus encouraging exports as well as tourism.

The current hot topic is that of the European Central Bank (ECB) moving ahead with its own QE programme. The World Bank recently revised its growth forecasts for the Eurozone from 1.8 per cent in June of 2014 to 1.1 per cent in January 2015, and with close to 0 per cent interest rates and negative deposit rates, there was no way for the ECB but go the QE way.

What would be interesting to observe in the coming months is how the ECB’s QE would affect different countries in the Eurozone. If it all goes into the major exporter, Germany, how would worse-off economies react and whether or not that would lead to a serious consideration of an Eurozone exit.

In conclusion, we are looking at an era where countries, and the Eurozone, would aim to depreciate their currencies and stimulate growth by having more of their currencies in circulation, leading to increased economic activities, more exports and higher tourism numbers via cheaper currencies.

Now if the euro depreciates significantly — and it normally would especially versus currencies that are not pegged to it — the end result would be more euros in the hands of Europeans but ones that are worth less.

It will all come down to balancing how low should euro’s value be to spur economic growth but not significantly hamper the purchasing power of Europeans. Moreover, the ultimate result of the programme should have the desired result of encouraging economies such as of Greece, Italy and Spain, in addition to avoiding deflation and reaching the far off 2 per cent inflation target.

Then, there is a whole different scenario that might possibly be played out by African countries who have their Western and Central African francs pegged to the euro. Will they decide to devalue the franc, based on a similar logic of what happened in the 1980s when there were unfavourable trade terms, leading to the devaluation of the Central African franc by no less than half (Economist 2002).

The next thing to watch is whether there will be a decision to unpeg the franc from the euro, and how such a decision will affect connected African economies, as well as ECB’s QE when these economies pull out their reserves as a natural result of the unpeg.

The thought I want to leave you with: how would currency devaluation help any country when all countries are devaluing their currencies?

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